“It stays. It stays. It stays. It is pointless to go short on the euro. It is pointless because it is going to stay. It is irreversible.” With those words, a visibly flustered Mario Draghi, the European Central Bank president, on Thursday sought to quash market fears over currency redenomination risks in the eurozone, at a press conference following the ECB meeting, where, as expected, the bank left rates unchanged.
Nevertheless, Draghi laid out a wide-ranging and historic blueprint for monetary action amid ramped-up expectations at a make-or-break meeting. However, few analysts reckon it signals a game-changer for the eurozone crisis.
First, Draghi said the ECB could embark on sterilized or unsterilized sovereign bond purchases at the short end of the yield curve “in a size adequate to reach its objective”, although noting German reservations. However, he signalled that troubled sovereigns would need to first access the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM), accepting “strict conditionality”.
Significantly, Draghi indicated that such ECB purchases would not necessarily gain seniority in any debt restructuring programmes, unlike the Greek bond saga whereby the subordination of private investors at the hands of the ECB highlighted the downside of the monetary authority’s Securities Markets Programme (SMP). Key to the ECB’s policy justification will be signs of “financial market fragmentation” that serves to impede monetary policy transmission, Draghi said, citing the collapse in cross-border eurozone lending and non-domestic interbank deposits.
But Draghi reiterated the fact that ECB action was dependent on governments making good on fiscal and structural reforms. Monetary policy can’t address “imbalances in current accounts and fiscal deficits... so that’s why conditionality is essential”, he said.
In addition to unveiling details of the ECB’s new framework for action in the coming weeks, Draghi said the ECB could implement “further non-standard measures”, interpreted as a revised collateral framework and more long-term refinancing operations (LTROs), although these instruments were only successful in inducing a two-month rally when first introduced last year. Finally, Draghi said the Governing Council had discussed the possibility of entering “uncharted waters” by taking the deposit rate into negative territory – with some analysts now expecting such action in September or October.
At first blush, Draghi’s comments signal decisive action, in particular by addressing the market-distorting issue of official-sector seniority in eurozone sovereign debt ownership combined with an historic suggestion that unsterilized debt purchases could be on the cards. Of all the humiliating U-turns Draghi’s predecessor, Jean-Claude Trichet, was forced to embark upon, unsterilized interventions – with the ECB effectively creating money to buy government debt – was not one of them.
 |
| ECB President Draghi |
But Draghi’s comments – hot on the heels of his rally-inducing commitment to “do whatever it takes to preserve the euro” last week – have had a disappointing market impact. Spanish bond yields at the short end have tumbled. But markets, more generally, were disappointed by a lack of immediate ECB action, with a jump in long-end peripheral European sovereign yield curves and a sliding euro. The Italian 10-year note spiked by 50 basis points just 10 minutes after the press conference and Spanish 10-year bonds are now back at seven-year yields, after the ECB made clear further measures will only benefit the very front of yield curves.
Some analysts were scathing at the absence of immediate policy measures, fearing that the ECB remains undecided on a road-map for action and Draghi impotent to convince Germany to use monetary firepower to shore up the solvency of neighbouring sovereigns. In short, some bearish analysts decided to focus on Draghi’s comments that the ECB only “may” embark on a new SMP – subject to formal sovereign financing requests – and his significant dismissal, citing legal constraints, of an ESM banking licence. (The establishment of the ESM itself still needs to be signed off by a German court, expected in September.) In the past week, an ESM banking licence had been hyped up as the only solvency-boosting vehicle for Spain, in particular, through pledging government bonds that it purchases as collateral for fresh ECB financing.
Market flop
To wit, Marc Ostwald, analyst at Monument Securities, said the meeting was much ado about nothing: “The council is clearly not in agreement on what can or will be deployed... and there are clearly a number of council members who are making further ECB action contingent on governments delivering on their side of the equation... and therefore whatever the ECB does will not be QE, notwithstanding his later comment on the issue of sterilization being undecided.” He added: “In truth if they have not decided on what they are going to do, then the issue of sterilization is in fact a little bit moot.”
But analysts at JPMorgan disagreed. “Draghi presented the outcome of today's meeting as the provision of guidance to the internal committees at the ECB, which will decide on the specific measures and their modalities in the coming weeks,” they said. “Nevertheless, [his indicative roadmap for action is] going to happen. There was only one dissent today, almost certainly the Bundesbank president Weidmann. Thus, when the specific details come to be voted on, there is no doubt in our minds that they will be approved by the Governing Council, which works on a simple majority basis.”
ING researchers were more balanced: “For Draghi, it was very hard to elegantly get out of such a self-inflicted dilemma. The ECB has to master a balancing act between keeping maximum pressure on eurozone governments, while at the same time not disappointing markets. Draghi managed this split in only a very rough-and-ready manner. It will definitely not earn him an Olympic medal in gymnastics.”
Virtuous circle
Markets now expect the EFSF and ESM to sign a memorandum of understanding of sorts with Italy and Spain to allow these programmes to purchase long-dated bonds while the ECB gives up seniority and embarks upon large-scale short-term debt purchases. But even if Draghi’s blueprint goes to plan, solvency fears remain.
First, the ECB’s short-term debt-buying commitment might encourage further bill auctions in Spain and Italy, exacerbating near-term financing risks, said Ostwald at Monument Securities. In the near term, Spain’s funding needs for the rest of the year aren’t too onerous, with the exception of €27.5 billion-worth of debt maturing in the last third of October; the Spanish bank bailout is likely to have the helpful side-effect of allowing banks to finance this borrowing, boosted by any third round of the LTRO. Italy still has around €120 billion left to source, and the treasury called a summer break on bond issuances in early June. But the Spanish government’s funding needs to 2014 amount to around €370 billion and Italy's a hefty €620 billion. But, as we have reported, although the mandates of the EFSF and ESM have expanded, their firepower has not. After taking into account Greece, Ireland, Portugal and Cyprus bailouts, the now-resolutely unlevered EFSF/ESM has only an estimated €350 billion left in lending capacity, a number that is set to fall to €210 billion when the EFSF expires in July 2013, reckons BCA Research.
Given Spain’s budget deficit is likely to hit 8.5% of GDP in the first half of the year, a full-blown Spanish bailout would exhaust the EFSF/ESM resources – leaving no money left for Italy.
In sum, there is little official-sector money currently available to depress long-term debt yields in Spain and Italy. Thus the ECB’s action is likely to be effective only if it manages to use its firepower to depress short-term yields while convincing markets that higher long-term bond yields will ultimately prove manageable for Spain and Italy. With this breathing room, Spain and Italy could begin to defuse their debt bomb if and when nominal growth rises in the coming years. But for these bullish chains of events to materialize the ECB might need to break a taboo: by publicly articulating its yield target. Failing that, it’s time for Berlin to put up or shut up.
Additional reporting by Nathan Collins